There was a cartoon where a man was gazing at a painting in an art gallery; he asked the art dealer, “What does that painting cost?” The dealer said, “I don’t know, how much money do you have?”
The cartoon represents the business valuation term Fair Market Value. While there are other standards of value, this is the most common. The IRS defines Fair Market Value as the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.
Often businesses find it necessary to obtain a valuation. These include instances of shareholder disputes, divorce, estate tax considerations and shareholder buy-outs. These are just a sampling of the need for a professional valuation.
Not having a professional valuation of your business can result in numerous expensive consequences. Examples include; shareholder litigation, unnecessarily expensive divorce cases, IRS challenges to gift and estate tax returns, increased attorney fees as well as needless stress and anxiety.
There are three approaches used to value companies. These approaches are typically examined simultaneously and then the most appropriate approach is chosen as the one applied. In some circumstances, a weighted average of more than one approach can be used,
- The Income Approach – quantifies the net present value of future benefits associated with ownership of the equity interest or asset. The estimated future benefits that accrue to the owner are discounted or capitalized at a rate appropriate for the risks associated with those future benefits. Common methods within the income approach include the capitalization of earnings (or cash flow) methodology and the discounted cash flow methodology.
- The Market Approach – determines fair market value by reviewing actual transactions of comparable companies and assets. Both M&A activity and stock market activity are considered in deriving various value measures to apply.
- The Asset-based Approach – uses the current value of a company’s tangible net assets as the key determinant of fair market value. This approach is typically used where a business is not a going concern, or where a business is a going concern but its value is tied directly to the liquidation value of its underlying tangible assets. The asset-based approach also provides a useful check when reviewing the value conclusions derived under the income or market approaches.
Valuation professionals have a wide berth in the application of approaches and opinions used to establish the valuation. Be certain that your professional holds a recognized certification in the valuation industry. While many accountants hold certifications, most do not. Should your valuation ever be subject to court scrutiny, beware of the potential for a challenge related to the qualifications of your valuation professional. This is known as a Daubert challenge.
As with art, beauty is often seen in the eye of the beholder. As such, be informed that few valuation experts will come to the exact same conclusion of value.
Summit Valuation Advisors